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Classification ACCOUNTING for SWAPS, OPTIONS & FORWARDS

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Classification ACCOUNTING for SWAPS, OPTIONS & FORWARDS ACCOUNTING FOR SWAPS, OPTIONS & FORWARDS AND ACCOUNTING FOR COMPLEX FINANCIAL INSTRUMENTS - Anand Banka GET THE BASICS RIGHT!!! | What is a financial instrument? | Classification | Measurement | What is Equity? | What are the types of Hedges? | Decision vs. Accounting 1 DEFINITION: EQUITY | the instrument is an equity instrument if, and only if, both conditions (a) and (b) below are met. y The instrument includes no contractual obligation: | to deliver cash or another financial asset to another entity; or | to exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavourable to the issuer DEFINITION: EQUITY …CONTD y If the instrument will or may be settled in the issuer’s own equity instruments, it is: | a non-derivative that includes no contractual obligation for the issuer to deliver a variable number of its own equity instruments; or | a derivative that will be settled only by the issuer exchanging a fixed amount of cash or another financial asset for a fixed number of its own equity instruments. For this purpose, rights, options or warrants to acquire a fixed number of the entity’s own equity instruments for a fixed amount of any currency are equity instruments if the entity offers the rights, options or warrants pro rata to all of its existing owners of the same class of its own non-derivative equity instruments. Apart from the aforesaid, the equity conversion option embedded in a convertible bond denominated in foreign currency to acquire a fixed number of the entity’s own equity instruments is an equity instrument if the exercise price is fixed in any currency. 2 INSTRUMENTS TO BE COVERED | Interest rates swaps | Stock index futures and options | Commodity futures and options | Currency futures and options | Other instruments May be for | Hedging | Speculation | Arbitrage RECOGNITION – CLASSIFICATION AND MEASUREMENT | Held for trading/ FVTPL | Measured at fair value | Subsequent – fair value, transfer to P/L | Fair value – quoted/ published prices/ transaction value 3 CALL OPTION - EXAMPLE | Option purchased on – 1st January 2013 | Contract size – 1,000 shares | Option price – Rs. 100 per share | Market price – Rs. 98 per share | Expiry date – April 30, 2013 | Premium – Rs. 400 Call Option (Asset) Dr 400 Cash Cr 400 CALL OPTION – EXAMPLE …..CONTD | Market Price on 31 March – Rs. 120 | FV? Call Option (Asset) Dr 20,000 Income Cr 20,000 Income Dr 300 Call Option (Asset) Cr 300 4 CALL OPTION – EXAMPLE …..CONTD | Settlement on 30 April | Market Price remains at Rs.Rs 120 Cash Dr 20,000 Expense Cr 100 Call Option (Asset) Cr 20,100 INTEREST RATE SWAP - EXAMPLE | Company issues Rs. 1,000,000 bonds | 5 yrs maturity | 8% Fixed Interest | Date of issue – 1st April 2012 Cash Dr 1,000,000 Bonds Payable Cr 1,000,000 5 INTEREST RATE SWAP – EXAMPLE …..CONTD | 5 year interest rate swap | Will receive 8% interest | Will pay variable rate (6.8% today) XYZ pays variable rate of 6.8% XYZ XZY pays fixed rate of XZY receives Company 8% fixed rate of 8% INTEREST RATE SWAP – EXAMPLE …..CONTD | Note: No entry required when Swap transaction entered into | However, FV of swap increases as the interest rate goes down and vice-versa | March 31: Interest Expense Dr 80,000 Cash (8% of 1,000,000) Cr 80,000 Cash (8%-6.8% Dr 12,000 Interest Expense Cr 12,000 6 INTEREST RATE SWAP – EXAMPLE …..CONTD | March 31: Swap Value Swap Contract (Valuation Assumed) Dr 40,000 Unrealised Gains (Income or Cr 40,000 Reserves??? Which Hedge???) Unrealised Gains Dr 40,000 Bonds Payable (WHY???) Cr 40,000 XYZ Company Balance Sheet as at 31 March COMMODITY FUTURES - EXAMPLE | December 2012: ABC company estimates purchase of 1,000 metric tons of Aluminum in April 2013 | Enters into Aluminum futures contract – 1,000 metric tons for $1,550 per ton | Note: No entry required on the date of entering into futures contract 7 COMMODITY FUTURES – EXAMPLE …..CONTD | March 31: Price for April future increased to $1,575 Futures Contract Dr 25,000 Unrealised Gains (Reserves or Cr 25,000 Income??? Which Hedge???) | April: Say price remains same… Aluminum inventory Dr 1,575,000 Cash Cr 1,575,000 Cash Dr 25,000 Futures Contract (Settlement) Cr 25,000 Why is inventory at 1,575,000? COMMODITY FUTURES – EXAMPLE …..CONTD | When the inventory is sold: Unrealised Gains Dr 25,000 Cost of Sales Cr 25,000 8 COMPOUND FI - EXAMPLE | Rs.1million 6% convertible debt | Repayable end year 3 | Market rate without conversion 10% Year Cash Flow DF NPV 1 60,000 0.909 54,545 2 60,000 0.826 49,587 3 60,000 0 .751751 45,079 3 1,000,000 0.751 751,000 Total 900,211 COMPOUND FI – EXAMPLE …..CONTD Particulars Debit Credit Cash 1,000,000 Liability 900,211 Equity 99,789 (Issue of convertible debt) Interest 90,021 Liability 30,021 C as h 60,000 (Finance charge year 1) 9 COMPOUND FI – EXAMPLE …..CONTD Particulars Debit Credit Interest 93,023 Liability 33,023 Cash 60,000 (Finance charge year 2) Interest 96,326 Liability 36,326 Cash 60,000 (Finance charge year 3) EMBEDDED DERIVATIVES An implicit or explicit term in a contract that makes a portion of the contract behave like a derivative/ change the original cash flows | Instruments with conversion features | Index-linked payments | Option to prepay debt | Transactions in ‘third currency’ 10 EXAMPLES Instrument Host Contract Embedded Derivative Debt Instrument ConvertibleConvertible bond DDeebtbt instrument CallCall option oonn equity securities Callable Debt Debt instrument Prepayment Option Equity Instrument Irredeemable convertible Ordinary shares/ Written call option preference shares Equity shares Leases Lease payments indexed to Operating lease Payment determined with inflation in a different economic reference to inflation-related environment index It is important to note that although the requirement to separate an embedded derivative from a host contract applies to both the parties to a contract, the accounting treatments in the books of both the parties might differ. For example, in the above case if the lessor and lessee are in different economic environments and the lease payments are determined with reference to inflation-related index of the lessor’s economic environment, only the lessee would be required to separate the embedded derivative EXAMPLES Instrument Host Contract Embedded Derivative Operating lease payable in Operating lease Foreign currency foreign currency denominated rent paymentntss– foreign exchange forward contacts Contingent rentals based on Operating lease Contingent Rentals related sales in operating lease contract Executory Contracts Purchase/ sale of goods in Purchase/ sale Foreign exchange forward foreign currency contract contract Purchase/ sale of goods with Purchase/ sale Option to make payment in option to make payment in contract alternative currencies alternative currencies 11 WHEN TO SEPARATE? Is the contract Would it be a Is it closely classified as ‘fair No derivative if it Yes related to the value through was free host contract? profit or loss’? standing? No Split & separately account CLOSELY RELATED? | IAS 39 does not define ‘closely related’ | In general termsterms, an embedded derivative that modifies an instrument's inherent risk would be considered as closely related (inflation indexed rentals) | Conversely, an embedded derivative that changes the nature of the risks of a contract would not be closely related (inflation of a 3rd country indexed rentals) 12 ACCOUNTING ON SEPARATION | Fair value the derivative | Reduce from the total cost | Residual is the value of host contract | No gain or loss on initial bifurcation ACCOUNTING | Apply IAS 32/39, or other applicable IFRSs if host is not a financial instrument | Measure the separated derivative at FVTPL | If it is difficult to separate the embedded derivative or otherwise if the entity intends not to do so, apply FVTPL to entire contract 13 CASE STUDY | An Indian company leases an aircraft from a Japan based company for 5 years. Monthly rentals of Euro 50,000 payable in arrears y What is the host contract? y Are there any derivatives embedded in it? y Do the derivatives need to be separated? SOLUTION | What is the host contract? y Lease contract (not carried at fair value) | Are there any derivatives embedded in it? y Yes, there are 60 embedded forward contracts to exchange Euro 50,000 for INR, which meet the definition of a derivative under IAS 39 | Do the embedded derivatives need to be separated upon entering into the lease contract? y Yes, each of these embedded forward contracts is a derivative that is within the scope of IAS 39 and is not closely related to the host contract 14 EXAMPLES | ABC Ltd. takes a loan with a bank. The contractually determined interest rate is calculated as [3 X LIBOR + 2] | Here, had the interest rate been [LIBOR + 2], the embedded derivate would have been said to be closely related to the underlying LIBOR rate and hence not separable. However, since the rate of interest depends on a multiple of LIBOR (called ‘leverage’ effect), the embedded derivate shall be separated REASSESSMENT | Assessment for separation when entity first becomes party to a contract | based on the conditions at that date | Re-assessment of embedded derivatives y Reassessment is prohibited unless | change in the terms of the contract that significantly modifies the cash flows 15 QUESTION | Which of the following contracts contain embedded derivatives that are required to be accounted for separately under IAS 39? Assume in all cases that the company is a UK company with a functional currency of Sterling. | A company has entered into a contract with a supplier in Eurozone (functional currency of Euro) to purchase inventory (cars). The contract is denominated in US Dollars. | A company has leased retail premises.
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